Empirical Literature on Financial Crises: Fundamentals vs. Panic

The process of financial globalization has given rise to an increase in the frequency of financial crises. With it, there has also been a surge in research about financial crises. One of the key questions in this area is whether crises are triggered by fundamentals or come as a result of panic. Observing real-world events, many prominent researchers, including Friedman and Schwartz (1963) and Kindleberger (1978), concluded that financial crises are so strong and sudden that there must be an element of panic in them. Yet, a large empirical literature (reviewed in the next section) has been able to establish a fairly strong link between crises and fundamentals. Theoretically, the panic-based approach to banking crises was formalized by Bryant (1980) and Diamond andDybvig (1983). In theDiamond–Dybvigmodel,when investors withdrawmoney from a bank, they deplete the bank’s capital, reducing the amount available for investors who come in the future. This creates strategic complementarities, such that investorswish towithdraw when they think others will do so. The result is multiplicity of equilibria. There is an equilibrium in which all the investors withdraw and an equilibrium in which none of them does. Crises are then self-fulfilling; they occur only because investors believe they will occur. In the Diamond–Dybvig model, the occurrence of a crisis cannot be linked to fundamentals. The fundamental-based (or information-based) approach has been modeled as well, for example, in Chari and Jagannathan (1988), Jacklin and Bhattacharya (1988), and Allen and Gale (1998). The basic idea is simple. Bad fundamentals (or negative information about fundamentals) lead banks’ balance sheets to deteriorate, inducing investors to run. The tension between the self-fulfilling approach and the fundamental approach to crises exists also in the currency-attack literature. The two classic approaches are presented by Krugman (1979) and Obstfeld (1996). According to Krugman (1979), the crisis is an inevitable result of a government that runs a fiscal policy which is